Pandemic puts direct lending in danger zone

Players in the direct lending market are sharpening their focus on portfolios, as companies battered by the coronavirus pandemic call on their creditors for help and concerns over deal structures intensify.

The pandemic hit following years of growth in the direct lending asset class. A May report by Preqin said the asset class has been "the success story of the decade" in North America, with assets growing to $222 billion as of June 2019, compared with $85 billion at the end of 2007. The COVID-19 pandemic, however, could lead to the asset class falling "out of favor," with opportunities set to be focused on distressed debt and other strategies. "Direct lending is likely to become more attractive during a recovery period, as companies seek financing to get back on their feet," the report said.

In Europe, direct lending deal volumes are expected to be less healthy than last year, Deloitte LLP said in its Deloitte Alternative Lender Deal Tracker Spring 2020 report. Deals totaled 484 in 2019, a 13.1% increase on 2018 numbers. European direct lenders raised the equivalent of $32.8 billion in capital to deploy, topping the previous record of $27 billion in 2017. Deloitte expects deal numbers in Europe to be down in 2020, reflecting a fall in mergers and acquisitions in the region amid the pandemic.

Money managers running direct lending strategies also reported a pause in fundraising as institutional investors stopped to reflect on their portfolios, with their attention largely diverted to their public markets exposures that bore the brunt of the coronavirus impact.

"Most institutional investors have been sidelined for the last three months working on their own portfolio allocations and issues," said Theodore Koenig, Chicago-based president and CEO at Monroe Capital LLC. "We are just seeing signs now of investor demand return to the market."

But when it comes to performance, the impact is not yet showing. "Short-term mark-to-market issues are all we have seen so far with everyone, but it is too early to tell if long-term performance will be an issue," Mr. Koenig said. "We need to get past the next couple of quarters to really determine if this will be a short-term issue or not."

The Cliffwater Direct Lending index, which measures the unlevered performance of U.S. midmarket corporate loans, returned -4.84% in the first quarter, its first negative quarter since the fourth quarter 2015, when it returned -0.28%. The U.S.-focused S&P/LSTA Leveraged Loan index, by comparison, fell 13.05% in the first quarter, while the S&P European Leveraged Loan index was down 15.14% in Q1.

As the market revives, a number of ongoing concerns — which until the onset of the COVID-19 outbreak and subsequent lockdowns had rumbled on in the background of the direct lending market — have been brought into the spotlight for money managers and institutional investors: the strength of deal covenants and the degree to which a portfolio company is leveraged.

"There has been a lot of dry powder with a lot of new funds and new entrants raising capital, which ended up chasing the same deals," said Thibault Sandret, a director on consultant bfinance U.K. Ltd.'s private markets team in London. "As a result of this competition, we have seen in recent years a deterioration in the risk-reward equation," with a compression in spreads and "a loosening of underwriting standards" in some cases.

Added to that is the trend across the globe for companies to adjust earnings before interest, taxes, depreciation and amortization or use add-backs, with fears among sources that deals are being overleveraged because of these figures. "When the economy and the debt come under pressure, you end up with companies in your portfolio that have a higher level of debt than if you had been a bit more disciplined," Mr. Thibault said.

Weaker covenants have been a global issue.

"Aggressive issuer-friendly terms were indeed features of the bull loan market that ended in early March," said Randy Schwimmer, New York-based senior managing director, head of origination and capital markets at Churchill Asset Management LLC — an investment specialist of Nuveen LLC — which has $24 billion in committed capital across direct lending and private equity funds. Executives in the direct lending team avoided covenant-light structures as a result of their experience during the last downturn.

"Not having performance triggers in the credit agreement deprives you of a critical tool to protect loan value. Having them in the current environment has been extremely beneficial," Mr. Schwimmer said.

However, the pandemic may help to strengthen covenants.

"The value of the financial covenant will be proven in this cycle, and the tolerance to entertain covenant-light in the middle market will be much lower post-crisis than it was before," said Taylor Boswell, New York-based CIO of Carlyle Group Inc.'s direct lending business, part of the firm's global credit platform. The firm has about $5 billion in direct lending assets under management. "But fully levered, covenant-light middle-market deals were really just emerging in the last 12 months, so they'll likely be nipped in the bud by the crisis," Mr. Boswell said.

Every time a borrower calls a lender to the table for help, they can claw back some terms to add protection to an existing deal, sources said.

"The topic people will be wondering about now is how much of that degradation will be recovered. And it's fair to say that in the current market lenders are recapturing a significant amount of the terms and covenant degradation that occurred over the course of the last cycle, both in new deals and through amendment activity," Mr. Boswell said.

Strong relationships with borrowers mean that "each time they come back to the table … (lenders) have an opportunity to improve documentation. So those financial covenants prove valuable in remedying weaknesses that may have crept in over the course of the cycle," he added.

But sources said their concerns are also being exacerbated by the structure of more recent deals.

"The unitranche lenders are now in a situation where … they've done highly levered structures and gone deeper down the capital structure," said Patrick Marshall, head of private debt and collateralized loan obligations at Federated Hermes Inc. in London. "That was fine if you did a loan with 30% equity before the crisis, but … that equity cushion has evaporated. And they've lent aggressively based on EBITDA add-backs. So they have high leverage, low equity buffers and many (of the portfolio companies) are cyclical businesses."

Those elements "in effect mean businesses are in far more trouble by the time a covenant is triggered," Mr. Marshall said. The firm — which does not split out direct lending assets, but has $4.1 billion in fixed-income strategies for the international business — takes a lower-risk, "conservative" approach, lending alongside banks and refusing to negotiate on loan terms in order to keep investors protected.

Deal structure is one of the biggest contributing factors to performance, said Leander Christofides, London-based co-CIO of J.P. Morgan Asset Management's global special situations team, which offers private debt expertise to institutional clients.

"As the market became more competitive … the value cushion" within structures has lessened, with moves toward unitranche deals, Mr. Christofides said. "From a distressed perspective it means a company is more likely to default, and when it does because there is no value cushion below you, recoveries are lower. We have seen that in recent data."

Mr. Christofides said recoveries a few months ago neared 60%. Today, loans that have defaulted are recovering at about 45%. "You can see this concept of a unitranche and no structural cushion below you has a real impact on recoveries."

Lenders have also had to work with portfolio companies to help keep them in business as the effects of shutdowns across the globe began to bite late in March.

"Immediately prior to COVID, the direct lending market was reasonably strong," said Peter J. Antoszyk, Boston-based partner at law firm Proksauer Rose LLP. "There were some companies that were experiencing problems, but, based upon our data, we saw a very low default rate in private credit loans — defaults during the last quarter of 2019 pretty much matched the broader syndicated leveraged loan market, at about 3%."

Then COVID-19 hit, but "we didn't see as many defaults as you might expect." Among Proksauer's data of more than 575 active loans that have closed, the firm tracked an overall default rate of 6% for the first quarter. The real question will be what happens in the coming quarters, Mr. Antoszyk said.

"Those companies that were weak going into COVID were tipped over and those matters represent most of our restructurings. For those companies that were reasonably strong and with decent balance sheets, it became all about liquidity, liquidity, liquidity," he said.

For the weak companies that suffered the most and required the most intensive restructuring, "we have not seen many liquidations. Instead, even for the weaker companies, we saw more companies that were sold as a going concern or reorganized," Mr. Antoszyk added.

As for the outlook for direct lending, market players think the asset class will make it through — but it might be rough seas.

"It will certainly survive COVID-19. That said, this current crisis is different" from the global financial crisis and the dot.com collapse, which direct lending funds in North America have already navigated, Monroe Capital's Mr. Koenig said. "Companies and businesses have been shut down and experienced little to zero revenues for an extended period of time. This was not foreseeable. Direct lending will need to assess the impact of COVID-19 on future periods and then factor that analysis into lending for transactional purposes," he said.

Market players are able to analyze future predictable cash flows and figure out a loan against those numbers. "If those future cash flow streams are not determinable with confidence or clear, direct lending will have no choice but to wait until the market can provide more certainty," Mr. Koenig added.

And that could take months, Proksauer's Mr. Antoszyk added. "The real question is what's going to happen" in the rest of 2020. "Liquidity is still an issue. It all depends upon when the economy will open up and when will revenue pick up."